Refinancing is beneficial for borrowers who want to get a lower interest on their mortgage and thereby save on monthly payments. However, many are having second thoughts about refinancing for the reason that they might risk losing the tax break they have on their original home loan.
Worry not. Your mortgage interest tax deduction will not be voided on the new loan. But if you tap into your home’s equity and get a cash-out refinance, certain rules apply.
First things first, you need to know if your debt qualifies. For instance, you owe $250,000 on your original mortgage and you refinanced to the same loan amount. You can continue the same interest tax deductions as you’ve had before.
To be eligible, your debt must either be on your first or second home. Remember, however, that you are limited to reducing interest only on the first million of qualified mortgage debt. The same limit applies if your first and second homes combined amount to more than a million in mortgages.
Cash-out refinances are like two loans in one. You borrow the original amount to pay off the old loan in exchange for lower interest rates, and you tap into your property’s equity to take it out as cash. This is where limitations are set.
Take for example you’ve refinanced for $200,000 on a mortgage that originally costs $150,000. Can you still deduct the interest? Yes you can. But only the $150,00 is qualified as home mortgage debt. It will be just as deductible as your old loan.
However, the exceeding $50,000 will be counted as home equity debt. So instead of the deductible first million, you can now only deduct interest on the first $100,000. The good side, however, is that you can use the money from your equity for whatever purpose you intend.
There is no limitation as to how you use the money you get from your cash-out refinance. But it’s good to know that if that excess amount you’ve borrowed on top of your original loan is intended to do improvements on your existing home, it could be counted as a home mortgage debt instead of a home equity debt. In this case, that amount is subject to higher deduction limits.
How to Calculate Your Deductions
- Write down the amount of your eligible mortgage debt.
- Divide it by the total amount of the mortgage debt. Get the decimal that has been rounded to three places.
- Take the resulting number and multiply it with your total interest. The resulting figure tells you the deductible portion.
- Make sure to report these changes on your Form 1098.
- Add the deductible mortgage interest to the deductible home equity debt interest (if there are any) on your income taxes.
- Report the total amount on line 10 of your Schedule A.
If you are still unsure, you can use various online calculators to calculate the deductible portion, or ask help from one of our professionals.